Description

A great deal has changed at Franklin Covey over the last year and half: a) the sale of the consumer business unit (~50% of revenue) in July 2008, b) a Dutch Tender for 17% of the company last Sept at $9.25, c) launched five new high growth businesses that should equate to 10%+/- of total revenue in 2009, d) the stock is 20% cheaper than Feb 2008, and e) the company is significantly reducing operating expenses. FC believes that their new businesses could be in the range of $60-100mn in additional revenue over the next three to five years versus the current $130mn, which we see as realistic as we will explain below. More importantly, FC has a model that should show very high incremental margins and significant earnings power. We think if FC executes even at a basic level the company should be able to reach $1.50-1.60 in EBITDA/ $1.20-1.30 in FCF over the next year and given could trade in the 8-12x range. The biggest reason we think FC can succeed comes down to distribution on a global basis, great products, a well known brand, and almost no penetrated on a number of products with significant revenue opportunities. The last seven years have not been exactly a great time to sell software into an HR suite yet SFSF has gone from -0- to $130mn in recurring revenue and $550mn market cap.

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What does Franklin Covey do today? Franklin Covey trains approximately 1 million people annually in 130 countries in areas such as Strategy Execution, Customer Loyalty, Education, Trust (see below), Leadership Effectiveness, and Time Management. FC has a highly diverse customer base with no customer concentration which includes 95% of the Fortune 100 and 75% of the Fortune 500. FC global training and consulting business earns economics on just under $200mn a year in annual revenue.

Investment Thesis:

60% of FC’s total revenue currently comes from outside US. FC is in 100 countries and is seeing the high growth opportunities in China (80 employees), India (300 employees), and Brazil. FC International licensees (excludes Japan, Australia, UK, Canada, which FC owns outright) earns 15% of revenue in royalty payments. This business has grown from $25mn to $70mn over the last 5 years (24.5% CAGR) and is in the early phases of long term growth.

FC is planning on taking reducing operating expenses by the equivalent of 10% of the market cap from 2009 to 2010.

Launched five new businesses in CY 2009: Live Clicks (web based), Insights (web based), Customer Loyalty Portal (web based, The Leader in Me (K-8 education product), and The Speed of Trust. We estimate from 2008 to 2009 these businesses should go from -0- in revenue to $11-12mn +/- or about 10% of total revenue. We think these businesses can grow at 100% in 2010. Management has guided the largest portion of these new businesses, Customer Loyalty Portal should grow from $5.5mn to $11mn in 2010 given that the company expects to go from 8 current customers and add between 8-11 in 2010 (each customer when fully implemented should produce a min. of $1mn per year). These new businesses have attractive economics with 65%+ GM’s.

Enterprise Rent A Car (6,100 locations) and Advance Auto Parts (3,000 locations $4.5bn mkt cap) are rolling out FC’s Customer Loyalty Portal.

Hallmarks of a Great Business: Targeting DSO’s low 40’s, Capital Intensity as mgt defines (AR + INV + CAPEX/Sales) should be around 15%, Revenue per employee should be $370-430K, User satisfaction as defined by Net Promoter Scores 70% (recently an industry contact told me “Franklin Covey is one of very few co’s that I know of that will turn down business if they do not feel they can add value, which is a real sign of integrity).” Recurring revenue is now in the mid 40’s and company is targeting mid 60’s over next few years, EBITDA -CAPEX should run in the 12-13% over the next year. 

Facilitator business: FC has 9,000 active certified facilitators that are employees inside corporations that train other employees on FC’s principles in various areas. This business has 78% GM and does $33mn in revenue. This business is pretty sticky as it comes to about $250 a month to train workforces on a very cost per employee basis.

Training is a highly fragmented industry of about around $6-7billion in the US alone. FC only has about 50% US market penetrated today and can add sales people (client partners) for a long time to come with attractive unit economics (explained below)

Long term trends: Gross margins have improved every year for eight years in a row from high 40’s to low 60’s as the company has divested less attractive businesses. FC has repurchased $140mn worth of common at avg. cost of $11 over the last ten years or so.

We think FC could hit Free Cash Flow estimates (August Year end): $1.30 in 2010, $2 in 2011 and $2.75 in 2012 (excluding share repurchases)

FC derives the economics that are much more significant than revenue would indicate. FC’s training business should generate on a global basis just under $200mn a year vs. the reported $130mn+/- ($120mn US, UK, Japan, Canada, Australia and the Licensee from 130 countries pay royalties of 15% of sales or $10mn/.15= $70mn).

Issues: Some parts of the business have slipped (time management and sales performance group), the previous guidance will be off by a quarter or two (guidance: $23mn in run rate EBITDA). They are not seeing cancellations but about 10% of revenue last quarter was deferred mainly into the 4Q09. There is a chance more business could slip. Again the cancellation rates have remained steady. Additionally the operating expenses on the domestic business are too high. Management has so far hit there targets in cost reductions and highly confident in significant additional reductions.

We think the upside on FC is low to mid teens based on 8-10x EBITDA our 2010 estimate of $1.50-1.60 and downside should be $5+/- (around 3x EBITDA). Over time we think the upside is significantly higher than the mid teens if the company achieves low 20's FCF margins.

CEO: We think very highly of FC's CEO Bob Whitman. A quick bio: Bob took over as CFO of Trammell Crow in the late 1980's when he was 35, and successfully worked the company out of $15bn in debt and was then appointed CEO of Trammell Crow Ventures. He Co-founded the Hampstead Group (a private equity firm in Dallas). He invested in Wyndam Hotels when the company had $13mn in revenue and grew it to nearly $1bn in revenue and sold it in the late 1990's. From what we can tell Bob has a long track record of investing success. Bob has consistently done the right thing for shareholders over time. Bob is an 8 time Iron Man Triathlete. He is highly disciplined and metric driven CEO. I would not consider Bob promotional. For several years he thought it was appropriate to hold just one conference call a year for investors. Conference calls are now quarterly and the company is actively seeking Wall Street coverage. Bob has a unique perspective of operator to investor to operator and acts the way many VIC members probably would if they were running the company. 

CEO Bob Whitman's: 4 key objectives and comments from 3Q09 (July 2009) cc:
a) Build revenue momentum and pipeline

"Our revenue backlog is very solid. We have a little more than $3 million more revenue on the books to be delivered over the coming quarter than we had at this time last year. Our current booking pace, we expect the backlog will grow further during Q4. Our bookings were holding up well…..Our pipeline of sales opportunities is significant and we’re actually beginning to see some deepening in that with a meaningful increase in the amount of potential business we’re discussing with existing and potential clients. There’s also a sense of firming in the delivery schedule associated with our bookings. "

b) Get EBITDA/Sales to mid-teens target
"We’re very confident in our ability to meet the central cost targets for Q4, Q1, Q2 and Q3 of next year that are set forth in slide five."

"As shown we expect the central costs in Q4 to be more than $4 million less than last year. That will help us obviously a lot in the fourth quarter in addition to the revenue momentum, and over the next four quarters we expect our central costs to be approximately $8.5 million lower even than this year as we annualize these cost reductions."

c) Monetize Balance Sheet
"1) By reducing our receivables days’ sales outstanding, 2) by reducing inventories and 3) selling our Canadian office warehouse building, and we’ve made good progress on each of those fronts. "

Note: DSO's are down to 58 and guiding to low 40's within 4 to 6 months,

Real Estate in Canada sold for $2mn (closed July 2, 2009)

d) New revenue and strategic initiatives

Live Clicks: http://www.franklincovey.com/tc/events/liveclicks
Insights: http://www.franklincovey.com/tc/events/insights FC was missing about 25-30% of their market by not having a downloadable webinar’s for employees that could not take time off and are usually hourly workers.
Leader In Me: $25K per school per year 140 schools and growing, funded by corporations.
Customer Loyalty Portal: (more below)

Maturation of Client Partners (sales force): First year expectations - $280k in revenue and costs company ($48K); Fifth year expectations - $1.2mn in annual sales and company pre-fixed overhead makes just under $600K

International Licensees: Significant amount of US content that could be sold overseas.

Practices are businesses that management believes can each reach $15-25mn+ in 3 to 5 years

• Trust
• Execution
• Customer Loyalty
• Education

Customer Loyalty is headed by Sandy Rogers and works with Fred Reichheld (a former 20 year partner at Bain and inventor of Net Promoter Scores). For this practice FC is targeting customers with a minimum of 1,000 retail locations.  Advance Auto Parts (AAP $4.5bn mkt cap) which is run by the former CFO of Best Buy is rolling out FC's Customer Loyalty Portal to all 3,000 retail locations. The results from FC's Customer Loyalty Portal will dictate a more and more significant part of each of AAP's 49,000 employees. AAP has made FC's Sandy Rogers a special advisor to their board. FC has guided to $1mn in annual revenue per 1,000 locations implemented and the contracts are long term (~3 years). FC has signed 8 customers in 2009 and estimates adding an additional 8-11 in 2010. Just with this base we would expect a minimum of $19mn a year in revenue once all are fully ramped up. Advanced Auto Parts alone, once fully rolled out should generate $4mn in annual revenue. Here is Sandy's background: http://www.franklincovey.com/tc/about/executive_team/sandy-rogers and Fred’s background: http://en.wikipedia.org/wiki/Fred_Reichheld

We think FC’s Customer Loyalty Portal has a significant growth trajectory ahead. As a point of reference a company called Success Factors (SFSF) which is a human resource oriented web based product suite and has gone from -0- to $130mn in recurring revenue over the last 7 years and trades at 3.5x sales ($550mn mkt cap) and just crossed CF b/e.

Education which is targeting K-8 with basically the 7 Habits for Kids called The Leader In Me has added 140 schools with or about $$3.5mn in revenue in first couple months. There are about 125,000 schools in US, so clearly a lot of room to grow in the US. The annual cost is $25K annually per schools and is paid for by corporations, after the first year the cost drops to $5-7K a year and is web based.

These are all 65-70% GM businesses. Hitting these objectives gets us to a $200mn+ business in 3 -4 years and the incremental margins should get us to 20%+ FCF margins with the potential for $40-50mn in FCF, which is about $3 a share. These practices should add $60-100mn in incremental revenue over 3-5 years.

We think that the growth in Live Clicks/Insights will be significant over the next 2-3 years through US and International; for half a year FC is estimating $1mn in revenue.

We have heard that McKinsey and Bain generate about $600K in revenue per employee, FC is guiding to a still impressive $370-430K going forward. In 2002 this was only $192K.

FC measures capital intensity of the business (AR+ INV+CAPEX/REVS) and is guiding to slightly under 16% for the business going forward. 

FC is guiding to having recurring revenues move from mid 40's to mid 60's over the next few years.

FC owns a 19% economic ownership in private company Franklin Covey Products. We do not ascribe much value to this maybe .40-.50 a share.

FC has a fairly low after tax cost of capital somewhere in the 2.5-3% range. On balance sheet the company is getting 8% Peterson note (acquired FC’s consumer business) and 10% on a small $1mn note.

CEO indicated that the vast majority of all excess cash will be used to repurchase stock and/or pay dividends (so far company has bought back $140mn at an avg. cost of $11).

Long term growth prospects: essentially the vast majority of FC revenue comes from countries that have a total population of 500mn. FC is in 140 countries and has barely made a dent in countries outside of US, Canada, UK, Japan, and Australia. This should change as emerging partners continue to ramp up use of current US based content and add client partners (especially Brazil, India, and China). Many Fortune 500 customers have a global footprint which should help to expand internationally as it has over the last 5 years.

Sustainable Competitive Advantage:

A) Brands/User Satisfaction: FC's "thought leaders" have sold over 18mn books based on various business strategies. Company grades out their services by Net Promoter Scores which currently run around 70. (As many will see NPS are becoming used more and more to gauge user satisfaction: I recently saw the investor presentation from VPRT and HD, which now include these metrics) 

B) Distribution model - US and Global: should allow very broad distribution (80 salesmen in US/operate in 100 countries) of high margin content (65-70% GM) and give significant scalability to the model. The business should have low fixed costs and high variable costs, given the reduction in central fixed overhead. Sales people and speakers are paid on transactions and days worked (eg the variable costs)

C) "Installed Base": FC trains about 1 million employees annually and has an additional 9,000 Facilitators ($35mn business) that provide training for employees in corporations that train other employees. The facilitator business is a fairly sticky high margin business that generates about $35mn in annual revenue.

D) Corporate Accountability: CEO to Client Partners (CP’s = Sales Force): CEO passed on a salary for three years when the employee loan program did not work out in exchange for 1.4mn options that struck at $14.00, stock was at $2 (these expire in July 2010); CP's have expectations of revenue and EBITDA per employee per year going from $200K and ($48K) respectively in year 1, to $1.3mn in booked sales with $500K in EBITDA by year 5.

Share Count: Pre-Sarbanes Oxley, FC did not want to dilute shareholders and got a bank to collectively loan employees $28mn to buy 3.5mn shares at $8. In 2002, FC hit a low of $1 and FC repaid the loan in full and put these 3.5mn shares in escrow; interest accrued on this loan is $49mn/3.5mn or $14 a share. When the stock hits $14, the loan is forgiven and the shares come out of the share count. The CEO and other investors own a combined total 6.5mn warrants that strike at $8 and expire in 3.5 years. Regarding the employee loan there is either a $49mn off balance sheet rec'ble or 3.5mn fewer shares outstanding. These two factors should largely offset much dilution over time. 

Very brief video’s for FC new products

Strategy Execution

http://www.youtube.com/watch?v=ahH2WdrovPg&feature=channel_page

Customer Loyalty

http://www.youtube.com/watch?v=i9Xda3xKKMI&feature=channel_page

Speed of Trust

http://www.youtube.com/watch?v=MFlIgNesNM0&feature=related

The Leader in Me

http://www.youtube.com/watch?v=oC3SuQeQ84o&feature=related

FC should have reasonable cash position over the next few months of likely over $10mn.Year ends Aug 31. We think FC should generate about $5.5-6mn in EBITDA this quarter+ $2mn from sale of Canadian real estate, Peterson partners owes FC about $5mn due in Jan 2010.

Risks: Additional slippage of revenue, Not taking costs out fast enough, there are some less sticky parts of the business in time management that have led to yr/yr declines in revenue the last three quarters, FC is at an inflection point the results are not there yet.

Disclaimer: This does not constitute a recommendation to buy or sell this stock. We own shares in this company, and we may buy or sell shares at any time without updating the board.

Positives: See intro and catalysts.

Catalysts:

• Investor discovery that FC training business is a high quality business with decent growth prospects that has attractive earnings power  
• Mgt confident that the company can take $12mn in cost out of the business: (13% of the market cap)
• Five new businesses growing at very high rates with high GM (2008 – 0; 2009 – $12mn; 2010 – $24mn)
• Significant amount of cash should hit the balance sheet over the next 6 months, to bring the company to no net cash position
• EBITDA should be $1.50-1.60 in 2009, peer group trades 8-10x range. We think FC should trade at a higher multiple than its peers due to International Licensees that pay high margin royalties and new web based products are growing at attractive rates.
• CEO on the April earnings call said he expects additional Wall Street coverage (Barrington Research started coverage yesterday with $10 target)
• Mgt stated all excess cash will be used to buy stock or pay dividends (supported by track record).

Catalyst

See above